Title: Monetary policy in a dual currency environment
Abstract: AbstractWe develop a small open economy general equilibrium model with sticky prices and partial dollarization – a situation where both domestic and foreign currencies coexist. We derive a tractable representation of the model in terms of domestic inflation and the output gap in which a trade-off, which depends on the degree of dollarization, arises endogenously due to the presence of foreign interest rate shocks. We use this framework to show analytically how higher degrees of dollarization induce larger volatilities of the output gap and inflation, thus hampering a central bank’s effectiveness to stabilize the economy. Our impulse response functions show that the transmission of such shocks has a positive (negative) effect on inflation and negative (positive) effect on the output gap when money aggregates and consumption are complements (substitutes).Keywords: dollarizationcurrency substitutionpolicy trade-offstaggered price settingopen economyJEL Classification: E50E52F00F30F41 AcknowledgementWe would like to thank Nicoletta Batini, Jess Benhabib, Pierpaolo Benigno, Paul Castillo, Luca Colantoni, Roberto Chang, Thomas Cooley, Mark Gertler, Ricardo Lagos, Gonzalo Llosa, Paul Levine, Carlos Montoro, Sydney Ludvigson, Fabrizio Perri, and seminar participants at the Central Bank of Peru and the 2002 meeting of LACEA for helpful comments.